Pimco Seeks Protection From Inflation in Australia, U.S.

Pacific Investment Management Co.,
which runs the world’s biggest mutual fund, favors inflation
protection in Australia and the U.S., betting stimulus efforts
around the world will stoke faster price increases.

“Central banks have implemented increasingly far-reaching
policy measures and they are more willing to take inflation risk
as a trade-off for growth and employment,” Michael Althof, a
senior portfolio manager in Munich, said in a phone interview.
“Index-linked bonds are good assets to have, as longer-term we
think the pressure for higher inflation is there.”

Australian inflation bonds returned 8.4 percent this year
through yesterday, the most among AAA rated issuers of the
securities, according to Bank of America Merrill Lynch indexes.
That’s greater than a 5.6 percent return from a global index of
inflation-linked sovereign bonds and 3.9 percent for
conventional government debt.

The securities are outperforming because central banks from
the Federal Reserve to the Bank of England and the Bank of Japan (8301)
are buying bonds to put downward pressure on borrowing costs and
spur growth. The Fed said Sept. 13 that it will buy $40 billion
of mortgage bonds a month until the U.S. sees what Chairman Ben S. Bernanke described as an “ongoing, sustained improvement in
the labor market.”

As well as paying a coupon to investors, the principal on
an index-linked bond grows in relation to the inflation rate.
Pimco bought Australian securities because the country offers
one of the highest yields after inflation, known as real yields,
in developed markets, Althof said.

‘High Quality’

The yield on the Australian index-linked note maturing in
September 2025 has dropped to 0.65 percent from 1.39 percent at
the start of the year. It’s still higher than minus 0.51 percent
on U.S. securities of a similar maturity and German 10-year real
yields at minus 0.33 percent.

Even as the economy of China, which buys about 28 percent
of Australia’s exports, is slowing, economists in a Bloomberg
News survey estimate Australia’s economy will expand 3.6 percent
this year and 2.95 percent in 2013. Treasurer Wayne Swan is
meanwhile cutting spending in a bid to end four years of
deficits.

“Australian bonds are attractive because of their high
quality and the country’s strong balance sheet,” said Althof.
“We may not be as bullish as we were in the past because the
real yields have come a long way, but if you look for positive
real rates then Australia still offers value.”

Australian consumer prices gained more than economists
forecast last quarter, rising 1.4 percent from the previous
three months, while analysts forecast a 1 percent gain.

Rate Cuts

The Reserve Bank of Australia has cut its key interest rate
by 1.5 percentage points to 3.25 percent since November last
year to support growth. It remains the highest benchmark rate
among major developed economies, though traders are pricing in a
56 percent chance the central bank will lower borrowing costs
again next week, according to swaps data compiled by Bloomberg.

Swan said two days ago the country can operate with lower
interest rates than it has in the past as overseas investors
buttress the local currency and help contain inflation.

Pimco also bought U.S. Treasury Inflation Protected
Securities against nominal bonds, betting inflation expectation
will rise, Althof said. The company prefers bonds with a
maturity of 10 years and longer he said. The U.S. 10-year break-
even rate, the difference between conventional and inflation-
linked securities, was at 2.52 percentage points yesterday,
compared with an average of 2.02 percentage points in the past
five years.

Adding Stimulus

The Fed is adding to stimulus after already pumping $2.3
trillion into the market in a bid to push investors toward
riskier assets. The Citigroup Economic Surprise Index, which
shows whether U.S. data beat or fell short of forecasts, climbed
to 55.5 on Oct. 15, the most since February.

Central banks that stick to their mandate of keeping
inflation in check would risk quelling growth and even
triggering “deflationary pressures,” Manoj Pradhan, an
economist at Morgan Stanley in London, wrote in an investor
report on Oct. 31. They need to allow for higher inflation until
the public and private levels of debt are lowered, Pradhan said.

“We expect inflation expectations in the U.S. to increase
over time because of the Fed’s policy,” said Althof. The near-
term “part of the market tends to react more to oil, food
prices and currency risks. Further out, they react more to
expectation and the central bank’s policy stance. This is our
favorite part.”